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Daniel H. Hyman, Jason Mandinach
The U.S. securitized mortgage market has performed well since the 2008–2009 financial crisis. Agency mortgage-backed securities (MBS) have generally benefitted from accommodative monetary policies, which have suppressed volatility, as well as over $1.6 trillion in direct Federal Reserve MBS purchases. Residential and commercial MBS have benefitted from the sharp recovery in real estate fundamentals, limited new supply (especially on the residential side) and investor demand for yield. While performance across the mortgage sector has generally been quite strong, PIMCO’s outlook in The New Neutral calls for tempered return estimates across asset classes. As a result, PIMCO’s Mortgage Opportunities Strategy is focusing on three key themes: selective offense, targeted defense and investing in the future of real estate finance.
Selective offense Non-agency residential MBS. Despite strong performance in recent years, we believe the legacy (pre-crisis) non-agency RMBS remain attractive. Prices are higher, but housing fundamentals have also improved materially since U.S. home prices bottomed in early 2012. While PIMCO expects home price appreciation to slow, we feel legacy non-agency MBS provide value with less interest rate risk than traditional core fixed income sectors. Idiosyncratic risks – in litigation, servicing transfers and securities that have largely amortized – present further opportunities.
European MBS. An accommodative European Central Bank has helped reduce much of the tail risk in European credit markets. As a result, both European residential (Irish, in particular) and commercial MBS may provide attractive return profiles in PIMCO’s base case scenarios, which include a gradual improvement in broader European economic conditions.
Structured agency MBS. While valuations are rich, unique return opportunities may be available in select structured agency MBS. In The New Neutral, we expect a lower future fed funds rate than the market is currently pricing in. Consequently, we have targeted agency MBS with inverse coupon structures – coupons that move inversely to short-term interest rates. Our prepayment analytics identify opportunities where prepayment risks can be mitigated, potentially resulting in an efficient vehicle to position against a realization of the forward yield curve.
We have also targeted interest-only (IO) securities that can provide positive returns when interest rates are rising. Less refinancing activity means that investors receive interest payments for longer than the market may be pricing in. While not all IOs are attractively priced, select bonds with collateral attributes that are designed to provide downside risk mitigation from faster prepayments may provide stable current yields and potential price appreciation if interest rates rise.
Targeted defense Agency MBS. Despite Fed tapering, the Barclays Agency MBS Fixed Rate Index has outperformed like-duration U.S. Treasuries year-to-date. Valuations have reached extremes in many cases as the Fed’s demand continues to outpace issuance. Agency MBS issuance has been much lower than market expectations this year. While a short position in MBS sacrifices some yield today, we believe it is prudent from a value perspective. Furthermore, we believe valuations in certain coupons are so expensive that the yield pickup relative to Treasuries will not be sufficient if these bonds revert toward long-term “fair value” over the next 18–36 months (depending on the coupon). Notably, there has been no 18-month period over the last 20 years where the current coupon mortgage has not reverted to fair value or cheaper, according to our analysis. With the Fed exiting this market and private investors seemingly hesitant to add significant exposure, we expect MBS to cheapen in the months ahead.
Buying optionality. We believe one of the most underutilized opportunities in a low volatility environment is the ability to purchase optionality in an attempt to hedge your portfolio from adverse market events. We utilize options on both interest rates and MBS for this purpose in the Mortgage Opportunities Strategy.
Investing in the future of real estate finance Fannie Mae and Freddie Mac risk reduction. A strategic initiative of the government-sponsored enterprises (GSEs) over the past 24 months has been to reduce the risk they hold on their balance sheets. As a result, we have observed over $6 billion of “risk-sharing” transactions, in which the GSEs sell off first-loss positions on mortgage pools that they have previously guaranteed in order to reduce credit risk and draw private capital back into mortgage credit. So far, we have found that transaction volumes have been minimal and initial pricing has been fairly expensive (and remains so, even after recent cheapening) relative to similar credit opportunities within legacy non-agency MBS. PIMCO expects spreads to widen as the GSEs look to reduce significantly larger amounts of risk, creating opportunities for private investors.
Private label securitizations. Policymakers are focusing on igniting growth in private label securitization channels to help reduce the government’s footprint in housing finance. Nevertheless, this market is unlikely to entice investors, such as PIMCO, without material improvements in investor protections. Similar to GSE risk sharing, while valuations on these securities have been unattractive, we would expect spreads to widen if issuance increased materially. If private label securitizations return in size, at the right price and with proper alignment of incentives, we believe they will provide more options for today’s mortgage investors.
Buy-to-rent securitizations. The Federal Reserve Bank of Atlanta estimates that institutional investors have deployed $15 billion–$20 billion of capital to purchase 90,000–150,000 single-family homes and many of these investors have started to utilize securitization for financing. While we see this option as unattractive at this stage, if residential credit availability does not improve, growth in rent will likely continue. This could result in greater-than-expected growth in single-family rental securitizations.
A strategy for an evolving market MBS investing requires flexibility and the willingness to broaden your opportunity set. While future returns in securitized mortgages are unlikely to match those in recent years, mortgage credit risk and prepayment risk are highly complex, often misunderstood and have historically presented attractive risk-adjusted return opportunities. This is precisely why we launched the Mortgage Opportunities Strategy.
Past performance is not a guarantee or a reliable indicator of future results. Absolute return portfolios may not fully participate in strong positive market rallies. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
This material contains the opinions of the managers but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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